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Inflation Why To Worry Or Not

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A presentation I did on how to protect portfolios against inflation
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  • 1. Deutsche BankPrivate Wealth ManagementInflation: Why Worry, Why Not to Worry,and What to do if Youre Worried Marshall Gittler Chief Strategist, EMEA Place des Bergues 3 CH-1211 Geneve 1 Switzerland marshall.gittler@db.com +41 (0) 22 739 0463 May, 2011

2. Inflation: Why Worry Central banks real policy rates at or below zeroHyperinflationDeflation Central banks around the world sharply reduced their policy rates in response to the 2008 financial crisis, in many cases to zero. After taking inflation into account, the real policy rate is at or below zero in most regions except for Latin America.Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions Deutsche BankMarshall Gittler Private Wealth Management2011 Family Office & Wealth Management Conference 2 3. Inflation: Why Worry Major central banks expand their balance sheetsHyperinflation Deflation In addition to reducing the price of money, central banks have been aggressively increasing the quantity of money available by pumping up their balance sheets. This increases the supply of reserves that banks hold, which eventually should increase the amount of bank loans and hence the supply of money.Source: Bloomberg Financial LP, Bank of Japan, Bank of England, Swiss National Bank, Deutsche Bank Global Investment Solutions Deutsche BankMarshall Gittler Private Wealth Management2011 Family Office & Wealth Management Conference3 4. Inflation: Why WorryNarrow money supply is rising, broad money just startingHyperinflationDeflation The growth in narrow monetary aggregates, which the central banks control, came down sharply after its 2009 spike, buthas started to recover again. The broad aggregates which the market controls have also been recovering since the beginning of last year, but arestill well behaved. Large-scale inflation is not likely unless these broader aggregates start to rise sharply as well.Source: Bloomberg Financial LP, Deutsche Bank Global Investment SolutionsDeutsche Bank Marshall GittlerPrivate Wealth Management 2011 Family Office & Wealth Management Conference4 5. Inflation: Why WorryNarrow money supply is rising, broad money just startingMonetary base and M2 in the US and Eurozone We can see this difference particularly in the US and in Europe. The monetary base (MB), which consists of banksreserves at the central bank and cash in the hands of the public, has soared because of the extraordinaryquantitative easing in which central banks buy bonds from the market, However growth in the broader aggregates,which represent money available for spending, is still relatively tame.In the US, M2 is defined as M0 (bank reserves at the central bank plus notes and coins in circulation) plus deposits in checking accounts (M1) plus money in savings accounts, certificates of deposit up to $100k, and money market accounts. In Europe, the European Central Bank defines M2 as M0 plus overnight deposits, deposits with maturities of up to two years, and deposits redeemable with notice of up to three months.Source:Fed, ECB, Deutsche Bank Global MarketsDeutsche BankMarshall GittlerPrivate Wealth Management2011 Family Office & Wealth Management Conference5 6. Inflation: Why Worry Inflation has followed broad money growth in USBroad money growth and inflation over time in the USHyperinflation Deflation What would happen if broader monetary aggregates start to rise more rapidly? The relationship between therate of growth in broad money and the rate of inflation in the US is well established over long time horizons. Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 6 7. Inflation: Why Worry The same relationship holds across countriesBroad money growth vs inflation in several countries Hyperinflation Deflation This relationship is not unique to the US. It also holds in a wide variety of countries.Source: iMF, OECD, Deutsche Bank Global Markets Deutsche BankMarshall Gittler Private Wealth Management2011 Family Office & Wealth Management Conference 7 8. Inflation: Why Worry Inflation is also a fiscal phenomenon, not just monetary US and UK inflation, 1750~present HyperinflationDeflation15 Fiscal monetisationVolcker Consumer price inflation (% yoy, 11 year ma)during WWI clampsFiscal monetisation down on10 Napoleonic wars:US UKduring WWII inflationUS war ofdeficit monetised US civil warindependence50 Fiscal monetisation -5during Vietnam War; 1st industrial revolution:2nd industrial revolution: oil shocks productivity-led deflationproductivity rebound; Depression -10 gold finds 1750 17751800182518501875 19001925 1950 1975 2000 Inflation is not just a monetary phenomenon. Historically, when governments have run up big debts (usuallydue to wars), they have resorted to inflation in order to diminish the burden of paying back that debt.Source: Deutsche Bank Global Markets Research Deutsche BankMarshall Gittler Private Wealth Management2011 Family Office & Wealth Management Conference 8 9. Inflation: Why Worry How debt/GDP ratios have been reduced in the past1. Economic growth2. Substantive fiscal adjustment/austerity plans3. Explicit default or restructuring of debts4. A sudden surprise burst in inflation5. A steady dosage of financial repression that is accompanied by an equally steady dosage of inflation Source: C. Reinhart and M. Sbrancia, The Liquidation of Government Debt, Peterson Institute for International Economics WP 11-10 Deutsche BankMarshall Gittler Private Wealth Management2011 Family Office & Wealth Management Conference 9 10. Inflation: Why WorryFinancial repression and the US post-WWII debtThe US govt engineered negative real rates to reduce its debt The US had significant debts left after WWII. Strong growth helped to reduce these debts, but financial repression also played its part. Financial repression included: Interest rate ceilings on deposits, whichinduced investors to hold govt bonds. Regulations to ensure that govt debt playeda dominant role in domestic institutionsasset holdings, particularly pension funds High reserve requirements for banks Restrictions on the international movementof capital and on gold holdings Overall, low nominal interest rates(below nominal GDP growth) andinflationary spurts resulted in negativereal interest ratesSource: C. Reinhart and M. Sbrancia, The Liquidation of Government Debt, Peterson Institute for International Economics WP 11-10Deutsche BankMarshall GittlerPrivate Wealth Management2011 Family Office & Wealth Management Conference10 11. Inflation: Why Worry Inflation is politically easier than taxation Hyperinflation Only in taxation do people discern theDeflation arbitrary incursions of the state; the movement of prices, on the other hand, seems to them sometimes the outcome of traders sordid machinations, more often a dispensation which, like frost and hail, mankind must simply accept. The statesmans opportunity lies in appreciating this mental disposition. Friedrich Bendixen, German economist and banker (1864~1920)Source: Robert Hetzel, German Monetary History in the First Half of the Twentieth CenturySource for photo: Wikipedia Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 11 12. Inflation: Why Worry Fiat money makes it easier to create inflationUK price index through the ages (log scale) HyperinflationDeflation think that modern Dont central banking will prevent a reoccurrence of this phenomenon. On the contrary, modern central banking and the invention of fiat money (as opposed to money backed by precious metals( has made it easier for central banks to debase the currency. If we look at Great Britain, prices rose 10x in the 600 years from 1300 to 1900. They rose 100x in the following century, and most of that has occurred just in the last 65 years since WWII. Source: SG Securities,, Popular Delusions, 27 May 2010 Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference12 13. Inflation: Why WorryGovernment monetization of debt causes hyperinflationWeimar inflation caused by soaring monetary baseArgentina did the same more recently Notes: Data normalized with 1913 equal to 1. Observations are the natural logarithm. The monetary base is cash in circulation plus commercial bank deposits at the Reichsbank. From the end of WWI to 1924, the price level in Argentinian inflation, already running at 500% a yearGermany rose by almost 1trn times. by 1989, soared to 20,000% by 1990 as the monetary base rose 12,726% a year at its peak in In 1913, total currency in Germany was 6bn marks. early 1990.Ten years later, a loaf of bread cost 428bn marks. The cause of this inflation was monetization of debt Something that cost 1 cent in Jan 1988 cost $76 justby the central bank, the Reichsbank. four years later.Source: Robert Hetzel, German Monetary History in the First Half ofSource: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions the Twentieth Century 13 14. Inflation: Why Worry Banking crises often result in inflation as wellInflation and external default 1900~2006 A banking crisis is typically followed by external default. External default is typically followed by inflation. Source: Reinhart and Rogoff, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, http://www.nber.org/papers/w13882.pdf?new_window=1 Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference14 15. Inflation: Why WorryWhat is the actual inflation rate?Government changes in calculation method reduce stated inflation rate The US government haschanged the way it calculatesthe inflation rate 24 times since1978. If it were still calculated thesame way it was done in 1980,it would be closer to 10%. Technological improvementshelp to hold down the rate ofinflation, but you cant e

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